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Transcript of China Project Final
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China: Country Risk Project
Team Members:
Nancy Flowers
Heather Le
Lita Lum
Tammy Ramirez
Farrah Thompson
Bus5840: Financial Management Policy
Professor: Kimberly Gleason
June 19, 2011
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China: Country Risk Project
I. Introduction
China’s form of government is a communist state known as a People’s
Republic. The Chinese Communist Party (CCP) is the leading political party in China
(China). China’s population is estimated to be 1.34 billion people as of 2011 and
the per capita income is $865.03 per person. Some of the key economic
characteristics of China are that the inflation has gone down, but it is still at a high
amount. Inflation has been driven by higher food prices caused by problematic
weather last year and hikes in international food prices. The government says it will
allow a faster rise in China’s tightly controlled currency to cool prices by making oil
and other imports cheaper (McDonald, Joe 2011).
China’s GDP growth rate expanded 9.70% in the first quarter of 2011 over
last year’s amount. The major component allowing China’s rapid growth has been
exports. There are numerous Chinese dialects and many subdialects. The main
dialect spoken by 70% of the population is Mandarin. This dialect is taught in all the
schools and is the standard of government. Religion has its own significant value in
the life of Chinese culture. The five-sanctioned “patriotic religious associations” are
Buddhism, Taoism, Islam, Catholicism, and Protestantism. Buddhism is the most
widely practiced. Only two Christian organizations- - a Catholic church without
official ties to Rome and the “Three-Self-Patriotic Protestant Churches -- are
sanctioned by the Church Government (State). The major cities in China are: The
capital – Beijing, and the other major cities are Shanghai, Tianjin, Shenyang, Wuhan,
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Guangzhou, Chongqing, Harbin, and Chengdu. China’s climate is tropical in the
south to subarctic in the north.
Recent news about China is that they recently rejected U.S. criticism over
deteriorating human rights saying that China’s progress in human rights “is an
objective fact” (BBC, 2011). China‘s growth economic outlooks look broadly
favorable despite the effect of higher raw commodity prices and the earthquake
that occurred in Japan recently. Unlike U.S. labor laws, employment laws in China
are in some ways more protective of the employees. Employment contracts are
generally required and normally stipulate probation periods of no more than six
months. A thirty-day advance notice and good cause are normally required in order
to fire an employee after the expiration of the probation period (although employee
incompetence and currency business reverse are considered good cause subject to
certain restrictions). An employee can be immediately fired for serious conduct
(Carnes). China does have a black market value of $168 billion and this market
consists of several things from book piracy to cigarette smuggling to wildlife
smuggling.
China’s physical infrastructure clearly has superior roads, airports, power,
and manufacturing facilities. China has a high level of political corruption. The
Chinese government is aware that corruption is endangering political stability and
economic growth, and they have been pursuing an anti-corruption campaign
targeted at both the public and private sector to try to curtail the persistent
problem. Corruption is perceived to be a considerable problem in China and this is
substantiated by The World Economic Forum Global Competitiveness Report 2010
-2011 in which corruption is ranked as the third largest constraint for doing business
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in the country. Despite the obstacle posed by corruption, foreign investors are not
being scared off (Business, 2010).
China’s market remains attractive for the U.S. because they are committed to
their reform and opening-up policy as they will continue to build an open and
transparent legal environment based on relevant laws and regulations, in addition
to the rules set forth by the World Trade Organization (WTO) to embrace foreign
direct investment. What makes China’s market unattractive is the corruption of
counterfeit parts and the U.S. is convinced that China is not worth the risk solely for
cheap labor. In addition, China has done all types of industrial espionage episodes,
knockoffs from production overruns, the demand for investments in China, and the
poor quality of different products.
China is liberalizing its rule on religion. They are now having open churches
with was not available many years ago. There are many U.S. multinationals
companies operating in China such as, Capital One, Nestle, and McDonald’s. Due
to the fact that China is sending many of their students overseas for education, it is
becoming one of the most lucrative industries for several countries that trade with
them (China, 2009). The type of company I would recommend for this market
would be in luxury goods.
II. Financial Factors Affecting Expansion Decision The U.S. and Chinese positions on China's exchange rate policy have not
changed substantially over the previous year. Washington argues that by
maintaining a substantially undervalued exchange rate, China is gaining an unfair
competitive advantage that sustains a large trade surplus to the detriment of the
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United States and many other countries. China's exchange-rate policy is seen by
U.S. officials as playing an important part in holding back adjustment of global
imbalances and delaying a more balanced and sustainable recovery in the world
economy.
While acknowledging that China has allowed greater exchange rate
appreciation, the United States argues that much more needs to be done on a more
regular basis. Furthermore, the U.S. stresses that faster appreciation in the
currency is, in fact, in China's best interest. It will help deal with China's growing
inflation problem and will also facilitate other needed policy changes and economic
reforms, facilitate a speedier rebalancing of China's economy away from heavy
dependence on investment and exports toward greater reliance on consumption to
drive economic growth. Rebalancing its economy has been a policy objective of
China, and it stresses the need for a gradual transition to avoid disruptions in
continued rapid economic growth and employment. A more rapid-paced
rebalancing of China's economy over the next few years with a substantially faster
rate of Yuan appreciation is also not seen by the Chinese as necessary. In their
view, China did not create the problems that led to the economic and financial crisis
and faster appreciation of the Yuan will not solve the woes of the advanced
economies. This view holds that the advanced economies need to correct their own
policy imbalances, particularly sizable fiscal deficits. In addition, Beijing points to
problems created by the role of the U.S. dollar as the world's primary reserve
currency and the recent renewed quantitative easing of U.S. monetary policy. It
calls for a diminished reserve-currency role for the dollar as part of a more equitable
and resilient international financial system. While China is right that the reserve-
currency role of the dollar allowed the United States to run a persistent fiscal deficit,
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The history of China's Stock Market is quite elaborate and complex. It dates
back to the 19th century. The entire market is based around the Shanghai Stock
Exchange, but tied directly to two other exchanges in Hong Kong and Shenzhen.
The establishment of the stock exchange took a long time, as did the growth in the
business trading with foreign markets.
Establishment
1. Following the First Opium War, the Treaty of Nanking in 1842 established an
area in Shanghai known as the International Settlement. This development
prompted the emergence of foreign markets in the area. This culminated in the
introduction of securities trading in the late 1860s. In June 1866, the first share
list began to appear prompting a number of banks and joint-stock companies to
be formed. This was coupled by an interest in diversification for investors and
trading houses.
Boom
• During the late 1880s, the Chinese mining industry boomed. In 1891, the
Shanghai Sharebrokers' Association was established, creating China's first
stock exchange. Most of the shares were supplied by local companies and
banks took the opportunity to dominate the majority of the private shares.
By the turn of the century, Hong Kong and Shanghai banks had
consolidated the majority of the trading shares from foreign bases. In
1904, the Association moved to establish another exchange in Hong Kong,
expanding the grip of the Chinese market in the world economy.
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Closing
• In 1920, the Shanghai Securities and Commodities Exchange were
established. This was followed the next year by the Shanghai Chinese
Merchant Exchange. In 1929, the markets combined and officially formed
the Shanghai Stock Market. Rubber became one of the prime stocks at the
same time as a number of foreign companies, such as those from Japan,
began to consolidate its economic control of the Chinese Stock Market. In
1941, the Japanese military took control of Shanghai and the stock market
ceased operation. It reestablished itself shortly after the war, but was
closed in 1949 during the Communist Revolution.
Opening Again
• The Cultural Revolution ended in the early 1970s and Deng Xiaoping took
power over the nation. China reopened itself to foreigners in 1978. This
caused a number of companies to begin trading securities with foreign
firms again prompting a surge in economic reform and continued
development of businesses. A socialist market economy was established
during the 1980s. This ultimately led to the Shanghai Stock Exchange to
be reopened in 1990. At the same time, China opened a secondary
exchange in Shenzhen aimed more at technology and government
securities.
Hong Kong
• In 1997, the Hong Kong Stock Exchange was implemented into the
Chinese system. Due to the fact that Hong Kong had long been a British
protectorate, special laws were established for the area that made the
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Hong Kong Stock Exchange more privatized than either Shanghai or
Shenzhen. Both the Shanghai and Hong Kong Stock Exchanges are
located very close to each other and aid each other by trading divergent
securities. The most notable concept of the Hong Kong location is that,
unlike the other two exchanges, Hong Kong is a for-profit enterprise.
*See Chart B in the appendix for the stock market data for China.
China’s credit rating was raised by Standard & Poor’s to the fourth-
highest level as world-record foreign-currency holdings add to the nation’s
financial strength. The long-term rating increased to AA- from A+, according
to a statement made by S&P. The company also upgraded Hong Kong to
AAA from AA+. The outlook was stable in both cases according to another
S&P statement. Higher ratings may encourage investors to pump more
money into the fastest-growing major economy, complicating government
efforts to cool inflation and prevent asset bubbles. This decision echoed a
move by Moody’s Investors Service last month and a trend across emerging
markets, with nations from Indonesia to Brazil to Turkey winning upgrades or
positive outlooks. “The rating hike will increase the attractiveness of China
as an investment destination,” said Ken Peng, a Beijing-based economist at
Citigroup Inc. “The rating may be raised further, but it will take a while,”
Peng said, citing concerns over stimulus-linked lending that could swell
banks’ bad loans. In November, China’s exports and imports rose to records
and industrial production grew at a faster pace, highlighting the economic
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strength that may allow the government to accelerate the withdrawal of
economic stimulus.
Over the last five years, China’s development has increased and its foreign
debt stood at $323 billion at the end of 2006. China Development Bank, a so-called
policy bank that lends mainly to infrastructure projects, invested in Barclays PlC, the
U.K. bank competing to buy ABN Amro Holding NV in the largest financial-services
takeover. China Development has borrowed overseas in the past, and continues to
borrow to build and increase development. Over the last five years, Moody’s has
continued to highlight the improved strength and supervision of the large state-
owned commercial banks and upgraded the long- term deposit and debt ratings for
seven lenders to A1 from A2.
The yield on Critic Resources Holdings Ltd.'s $1 billion of U.S. dollar bonds
due in 2014 narrowed to 260 basis points, more than similar-maturity U.S.
Treasuries at 11:32 a.m. in Hong Kong, down from 285 basis points yesterday, the
lowest since July 23, according to Merrill Lynch & Co. The average yield since the
bonds were sold in May has been 214 basis points over U.S. Treasuries.
Although China’s Treasury bill rate is not available or published on the
internet for ordinary investors to evaluate, we expect the default risk spread or
solvent risk premium in China to decline in the next five years. This is mainly due to
trade surplus in China. Trade surplus lead to currency and capital surplus, as a
result, China would be less likely to default.
The political risk is high in China. Food and energy costs have continued to
rise in recent years. The Chinese government is very conscientious about the
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country’s inflation rate. High inflation would likely turn into riots as majority of the
China’s population is poor and more likely to revolt against the Chinese
government. Doing business in a developing country and in an emerging economy
can bring added risks of an undesirable political event that many investors are
simply not prepared to deal with on their own. Therefore, we recommend
purchasing the political risk insurance to mitigate the noncommercial risks. Such
insurance is offer by the Multilateral Investment Guarantee Agency (MIGA), a
member of the World Bank Group.
The financial risk in China is also high. China’s financial reporting is not as
transparent as the U.S. and other the developed countries. For instance, China
does not have a financial regulatory body to provide oversight on the financial
reporting like the SEC in the U.S. The accountancy evaluation and monitoring of
Chinese companies are done in a manner that is not exactly transparent. As a
result, foreign investors cannot rely on the financials prepare by Chinese companies
with respect to the completeness or accuracy of the information represented.
In the last five years, there weren’t any expropriation of foreign assets in
China. This is mainly due to the reason that China is trying to become a member of
the World Trade Organization (WTO) and want to have a good standing with foreign
investors. Entrance into the WTO will force China to take measures to change
customs, financial and legal procedures.
China has many restrictions on repatriation of profits. Today investors can
legally repatriate up to 90% of their annual profits from China, provided that they
fulfill certain norms made by the Chinese Government. For the profit repatriation
permission, companies need to set up local offices in China, file for the fourth
quarter tax returns (to finalize the net profit) and create a reserve account of at
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least 10% of the total net profit. The profit repatriation rules change according to
certain things, like if the business is a joint venture or if it is enlisted as a
consultant, etc.
The local banking system in China is unsophisticated. China’s banking sector
remains at its early stage of development, mainly working with loans and deposits.
Interest income is the main source of income, though fee-based business has been
growing fast. Fee and commission income include income from agency services
(such as payment disbursement, collection, settlement, clearings), cash
management, remittance and settlement, custody services, consulting and advisory
services, bank cards, and other services. Sixty-eighty percent of all loans granted
by the local banking system are currently granted in accordance to the systems laid
out in the five-year plans. The majority of these are to the benefit of state owned
enterprises (SOEs). The four major Chinese banks (Bank of China, Agricultural Bank
of China, Industrial and Commercial Bank of China, China Construction Bank) handle
82% of all financial business. Although the banking industry is still highly regulated,
China’s accession to the WTO has led to a lesser control by the government. China
is in the process of passing new laws aimed at bringing the country’s banking
system up to international standards.
To invest in China, we would have to raise capital outside of China, as China’s
RMB is not an international reserve currency. A reserve currency is currency use to
price goods and services between the two countries. The RMB currency is not
tradable and therefore the market is very limited for RMB.
There are many factors to consider before making the investment in China.
We have to beware of the political red tape as many businesses are still control by
the government. We would hire experienced local partners to help us establish our
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presence in China and work with the local government on foreign direct investment
limitations. We would hire local employees and provide them with lucrative
incentives to make the venture a successful one. We would train unskilled workers
in China to get up to par and also pay attention to the quality control to avoid
potential negative press. We would be required to raise substantial capital to enter
the new market. Such a huge investment in a foreign economy provides an added
risk that cannot be undertaken if the profits repatriation is limited by certain local
laws. One of the ways for the legal profit repatriation is to set up a financing
structure between the parent company in the U.S. and the subsidiary venture in
China. This would require the parent company to fund the subsidiary with a loan.
The subsidiary can repatriate its profit to the parent by making loan and interest
payments. The interest payments on the subsidiary are tax deductible and the loan
repayments are not taxable to the parent.
III. Management Factors to Consider
When investing abroad, one must consider the modes of foreign involvement
in terms of a sequence of decisions regarding where production is to occur, who is
to own or control intellectual property, and who is to own the actual production
facilities. When a firm decides to enter a certain foreign country, it has to choose a
mode of entry, which mainly includes the choice of a foreign target market, and the
objective and future goals of penetrating into the market. Management factors to
consider when doing business in China include deciding whether to export the
goods or produce them abroad. In addition, we would need to decide if licensing the
product or controlling the assets abroad would be more appropriate. Last, but not
least, managers must also consider whether they want their business to be a joint
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venture or a wholly owned subsidiary. Each mode of entry will be examined using
pros and cons to evaluate which approach may best be suited for the foreign
venture.
The advantage of exporting versus production abroad is that it does not face
the same unique risks as FDI, joint ventures, strategic alliances, and licensing. In
addition, agency costs and political risks are avoided as the amount of front-end
investment is typically lower than in other modes of foreign involvement. However,
some of the disadvantages include, not being able to internalize and exploit the
results of its research and development as effectively as if it invested directly. In
addition, foreign markets may imitate the product and penetrate back into the
exporter’s own market for much cheaper. The cost of exporting may be more
expensive as production costs and labor in foreign countries are cost efficient.
Global competitors and imitators may make this option less profitable as more
businesses penetrate the market.
Licensing is a popular method for domestic firms to profit from foreign
markets without the need to commit sizable funds. Since the foreign producer is
typically wholly owned locally, political risk is minimized. Typically MNEs sell their
services in “unbundled form” rather than only through FDI. Local firms can purchase
managerial expertise and knowledge of product and factor markets through
management contracts, and purchase technology through licensing agreements.
However, license fees that are lower than FDI profits, high agency costs, possible
loss of quality control, and the risk that the technology will get stolen are just some
of the disadvantages of licensing.
In deciding whether to be part of a joint venture in a foreign market or
become a wholly owned subsidiary entirely depends on the confidence of the
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business to remain competitive and culturally aware of local operations and policies
that take place abroad. A joint venture between a MNE and a host country partner is
a viable strategy if, and only if, the MNE finds the right local partner. Culturally,
having a local partner who understands the customs and local environment may
make the business transaction smoother when trying to penetrate into the foreign
market. The local partner can provide competent management and help to oversee
the entire firm. In addition, the local partner may have more access to contacts
which will help in getting the business started.
Depending on the size of the firm, it may be more profitable to go as a wholly
owned foreign subsidiary. This allows the company to make more independent
decisions without the interference of a foreign partner. Local and foreign partners
may have divergent views on how the business is run. In addition, political risk is
increased if the wrong partner is chosen. The success of a joint venture depends
primarily on the right choice of a partner. For this reason and a number of other
issues related to possible conflicts in decision making between a joint venture and a
multinational parent, the 100%-owned foreign subsidiary approach is more
common.
In order to bring the best leaders to manage a foreign workforce, a U.S.
manager should be compensated an equivalent amount abroad, if not more to “sell
the job” and motivate the manager to perform at their maximum level. With a lot at
stake doing business abroad, the compensation package should reflect the
manager’s skills and training in managing in a foreign environment. An
understanding of foreign policies and business cultures in doing business abroad are
some of the skills that are necessary for leading a successful venture overseas.
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IV. Summary and Decision
There are many benefits of expanding into the China market. China
has very good infrastructure. This means that they have good roads, power
supply, airports, etc. They are committed to reforming their policies so that
there can be a transparent legal system in place. China has cheaper labor
than most other countries. They have become an important factor in the
growth of the global economy. They have a major trade surplus. There are
more exports being shipped out than imports being shipped in. There has
been no expropriation of foreign assets in the last five years. A company can
repatriate up to 90% of their profit from China, provided they fulfill certain
norms made by the Chinese government. A company could purchase
insurance from the Multilateral Investment Guarantee Agency (MIGA) to help
mitigate political and noncommercial risks.
There are also many risks and costs involved. China’s per capita
income is very low. It is growing a little, but it is still very low. This could
mean that Chinese customers would not be able to afford many items. China
has a very high inflation rate. They have a high number of black market
goods. They also have high political and financial risks. The political
corruption is very high. There is a lot of political “red tape.” This endangers
political stability and economic growth. There is no financial regulatory body.
China has very strict employment laws and rules. They have an undervalued
exchange rate. The banking system is still in its very early stage. In order to
raise capital, the company would have to go outside of China. The food and
energy costs are high and continue to climb even higher. Many businesses
are still controlled by the government.
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If the decision was made to expand into the market, there are certain
things that would need to be done. The company should hire local
employees because of the cheap labor and provide them with lucrative
incentives to ensure they do a good job. These unskilled workers would need
to be sufficiently trained. A substantial amount of capital would have to be
raised outside of China. The financing should be set-up where the structure
between the parent company in the U. S. and the subsidiary company in
China can repatriate its profits to the parent company. The loan payments
made are non-taxable to the parent company. The interest payments made
to the parent company are tax deductible. A thorough understanding of
foreign policies and business cultures are a must. The company may have to
rely on exporting many of their products.
After examining all of the benefits, risks, and cost; the risks and costs
far outweigh the benefits. There is too much unrest and unease in China at
the present time. The political risks, corruption, and problems are very
troublesome. The high inflation, low per capita income, unregulated financial
system, young banking system, and the fact that too many things are
government controlled and government run would make a decision about
expanding into the market in China a very hard decision and one that would
probably best be declined at the present time.
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V. Sources Cited
Anstey, Chris. “China’s Debt Rating Raised by Standard & Poor’s”
December 16, 2010, 4:51 AM EST
BBC New – China rejects US criticism of human rights record, Retrieved on May 11,
2011
http://www.bbc/co.uk/news/world-asia-pacific-13358081?print=true
Business Anti-Corruption Portal, Retrieved on May 12, 2011 from
http://www.busienss-anti-corruption.com/country-profiles/east-asia-the-
pacfic/china/snaps
Carnes, David, Investing in China: Hiring, Firing and Labor Law, Retrieved on May
11, 2011
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http://www.streetdirectory.com/travel_guide/print_article.php?
articleID=13938
China GDP Growth Rate, Retrieved on May 11, 2011 from
http://www.tradingeconomics.com/china/gdp-growth
China: Havocscope Black Markets, Retrieved on May 11, 2011 from
http://www.havocscope.com/regions-main/asia/china
China Overview: China's Economy at Glance, retrieved on June 12, 2011
http://www.chinaknowledge.com/Business/CBGdetails.aspx?
subchap=1&content=1
China – Politics, government, and taxation, Retrieved on May 11, 2011 from
http://www.nationsencyclopedia.com/economies/Asia-and-the-
Pacific/China_POLITICS_G...
China – U.S. Department of State, Retrieved on May 11, 2011 from
http://www.state.gov/r/pa/ei/bgn/18902.htm#political
Gentile, Angela and Valahu, Philippe, MIGA in China: Political Risk Insurance Helps
Investors Push Projects Ahead, retrieved on June 14, 2011
http://www.chinabusinessreview.com/public/0403/miga.html
McDonald, Joe, China’s April inflation eases but still high, Retrieved on May 11, 2011
from
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http://news.yahoo.com/s/ap/20110511/ap_on_bi_ge/as_china_inflation/print
Profit Repatriation: The Foreign Direct Investment Incentive, Retrieved on June 14,
2011 from
http://www.buzzle.com/articles/profit-repatriation-the-foreign-direct-
investment-incentive.html
The Chinese Banking System and the prospects of foreign banks and operators,
retrieved on June 14, 2011
http://jpkc.szpt.edu.cn/english/supplement/banking%20system6.htm
WantChinaTimes.com, Retrieved on May 12, 2011 from
http://www.wantchinatimes.com/news-print-cnt.aspx?cid=1101&MainCatID=11&id=2011...
Zhang, Dingmin. “China's Debt Rating Upgraded by Moody's to A1 (Update6) “
Bloomberg July 26, 2007 06:12 EDT
VI. Appendix
Chart A
Below is the Chinese Yuan to U.S. Dollar Currency Exchange
Forecast.
Chinese Yuan to One U.S. Dollar. Average of Month.
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Month DateForecast
Value
50%
Correct +/-
80%
Correct +/-
0 Apr 2011 6.5267 0.000 0.000
1 May 2011 6.490 0.008 0.018
2 Jun 2011 6.447 0.010 0.023
3 Jul 2011 6.407 0.011 0.026
4 Aug 2011 6.380 0.013 0.028
5 Sep 2011 6.350 0.014 0.030
6 Oct 2011 6.320 0.014 0.032
7 Nov 2011 6.305 0.015 0.034
8 Dec 2011 6.300 0.016 0.036
Updated Tuesday, May 10, 2011
Chart B
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S & P 500
MSCI
China
Date Adj Close Date
Adj
Close
1/3/2011 1271.87 1/3/2011 22.250.733
2=Correl
12/1/201
0 1257.64 12/1/2010 21.85
11/1/201
0 1180.55 11/1/2010 22.45
10/1/201
0 1183.26 10/4/2010 22.8
9/1/2010 1141.2 9/1/2010 22.05
8/2/2010 1049.33 8/2/2010 20.45
7/1/2010 1101.6 7/2/2010 20.85
6/1/2010 1030.71 6/1/2010 20.4
5/3/2010 1089.41 5/3/2010 19.76
4/1/2010 1186.69 4/1/2010 20.85
3/1/2010 1169.43 3/1/2010 21.15
2/1/2010 1104.49 2/1/2010 19.92
1/4/2010 1073.87 1/11/2010 19.56
Positive correlation: Since the stock indexes have a linear
correlation, r is close
to +1. An r value of exactly +1 indicates a perfect positivefit. Positive values
indicate a relationship between x and y variables such that
as values for x
increases, values for y also increase.
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The correlation coefficient of these two stocks is 0.7332029 this
indicates a positive
relationship. On the one hand, this is good if the stocks areincreasing,
however if they are decreasing that would not be good.
A correlation greater than 0.8 is generally described as strong,
whereas a correlation
less than 0.5 is generally described as weak . These values can
vary based upon the
"type" of data being examined.